CLATs are irrevocable trusts that provide an annuity payment to one or more charities over an agreed-upon number of years, free from gift and estate tax at their completion.
With today’s record-low Section 7520 interest rate, non-grantor CLATs can offer significant gift and estate tax savings. In this article, we’ll look at two forms of CLATs: increasing payment IPCLAT and balloon IPCLAT.
Overview and Definitions
A charitable lead annuity trust (CLA Trust) is a tax-exempt trust that makes annual payments to GDS for an agreed-upon period. At the conclusion of its term, any leftover trust assets will pass to your family or other beneficiaries of your choosing; due to its fixed payout annually, it’s especially attractive when interest rates drop significantly.
Example:
George wants to give his children money without paying too much in taxes. He follows his advisor’s advice and creates a trust that gives 6% of its value each year to the Foundation. After 15 years, the remaining money goes back to him. He can also get a tax deduction for the amount given to charity.
Various varieties of charitable lead annuity trusts are available, from guaranteed annuity interest plans to unit trusts that pay a charity as a percentage of annually revalued trust assets. If you are considering creating one of these arrangements, consult your financial planner or estate planning attorney first so they can determine if this strategy would best meet your needs.
Benefits
With the recent reduction of Section 7520 charitable lead annuity rates, now is an opportune time to explore the advantages of Charitable Lead Annuity Trusts (CLATs). A charitable lead trust can conveniently pass appreciated assets directly onto family members without incurring gift and estate taxes.
CLATs’ governing documents typically specify that a percentage or fixed dollar amount of initial trust assets will be distributed annually as charitable donations in the form of guaranteed annuity interests or unit trust interests, respectively. If the trust reverts back to you or your spouse at its end of term, donors who itemize taxes can claim an immediate income tax deduction for its present value when it reverts back into you or them upon termination of the trust term.
If you are considering establishing a grantor CLAT, it is important to remember that any increase in asset appreciation will be factored into calculating generation-skipping transfer taxes. To prevent this issue from arising, it would be prudent to select both the term and payout rate accordingly to keep the denominator as low as possible.
How to Establish
Establishing a Charitable Lead Annuity Trust (CLA) allows you to transfer assets directly to charity while simultaneously lowering gift and estate taxes on what ultimately goes back into your family. A CLA can be established during either your lifetime or at death and provides one or more charitable beneficiaries with payments for an agreed-upon period; once this term ends, any remaining amounts will be distributed among all of your non-charitable beneficiaries based on fixed amounts, percentage of revalued assets per year (referred to as unitrust amounts), or both options.
Grantors of CLATs may claim an upfront deduction for the present value of the guaranteed annuity or unit trust interests, with an inclusion ratio not exceeding the applicable federal estate and gift tax rate (AFR). Therefore, while currently, donors might find CLATs unattractive given that federal exemption levels remain relatively low, as AFR rates reduce, they could become increasingly attractive as donors may reduce their tax burden and exemption levels increase; depending on how the trust is structured this strategy could also help avoid state inheritance taxes.
Tax Considerations
An annuity trust can be an ideal way for donors looking to make large gifts while still passing assets to family members at the end of its term. But before setting one up, it is crucial that legal and financial advice is sought as these trusts may become complicated over time due to external influences such as changing interest rates and federal tax law.
Dependence upon whether a CLAT is classified as a grantor or non-grantor trust can determine how it’s taxed; with grantor trusts, donors receive immediate income tax deductions equal to the present value of charitable annuity payments to charities, while complex trusts such as non-grantor CLATS must pay taxes as individual entities on all trust income generated within them.
Nongrantor CLATs must take note of two main considerations when operating as non-grantor CLATs: accumulation trust throwback rules may require some of their charity payments to be taxed as ordinary income, and they could face recapture rules for any property held for short-term appreciation.
Compared To Other Charitable Giving Strategies
CLTs provide significant estate tax and income tax benefits over other popular charitable giving strategies and may also meet various client objectives. They can be structured either as grantor or non-grantor trusts to meet client goals.
As with a Charitable Remainder Trust (CRT), a CLT can be set up to pay out annual payments to one or more charities over time, leaving behind any surplus to either its grantor or their heirs at death. Not only may donors claim an income tax charitable deduction at the time of the gift, but the CLT itself may enjoy tax-free investment growth as an added perk.
Charitable Lead Unitrusts (CLUTs) offers annual payments based on a fixed percentage of the fair market value of trust assets; when this arrangement ends, any remaining assets are distributed among noncharitable beneficiaries like the grantor or his or her children. When selecting the type of CLAT that best aligns with the client’s philanthropic, financial, and family goals.
Case Studies and Examples
Wealthy individuals tend to take steps to minimize gift and estate taxes so their family receives as much wealth as possible from them. This is particularly important during times of low-interest rates when planning with charitable lead trusts is an option.
As illustrated below, a donor can fund a grantor lead annuity trust with a 10-year term and transfer significant assets tax-free at its completion to children at its end. Assuming the IRS discount rate was at its historic low of 1.4 percent at gift time and its net present value earned 5 percent annual returns, assets transferred could total $250K+ over time.
Donors may also establish non-grantor lead annuity trusts with charitable income being distributed directly from them, while any remaining amount is divided among noncharitable beneficiaries. A donor would still report and pay tax on this accumulated income without receiving an offsetting annual charitable deduction for it.
Potential Challenges and Risks
With interest rates at historic lows, many high-net-worth individuals are inclined to make charitable gifts and seek to minimize gift and estate tax costs. Advisers assisting these clients should know all available tools to achieve their planning objectives.
One such technique is the non-grantor charitable lead annuity trust (CLAT). This split-interest trust provides annual payments to one or more charities for a specified term of years before dispersing remaining assets to the donor’s children free of gift and estate taxes at its conclusion.
Note that the CLAT governing instrument does not include a power to prepay charitable annuity or unit trust interests, as the IRS has indicated in private letter rulings and annotations to sample CLAT/CLUT forms that such a power would disqualify them from income, gift and estate tax deductions. Therefore, shorter grantor CLATS with higher payout rates may be more effective at mitigating transfer taxes.
Conclusions
A charitable lead annuity trust (CLA) is designed to provide one or more charities with payments over an agreed-upon term of years, making gift and estate taxes less burdensome during life and after death.
Recently, the Section 7520 interest rate has been at an unprecedented low point, which increased the value of lead annuity trust charitable deduction relative to grantor CLA of equal amount. When interest rates increase again, however, their value decreases and so do any taxable remainders in lead annuity trusts.
With low interest rates limiting our options for loan and lease arrangements (CLAs), nongrantor CLAs have become more appealing in today’s low-rate environment. By transferring ownership to a trust rather than directly to the Donor and being taxed as a complex trust, non-grantor CLAs allow any future appreciation to bypass a donor’s taxable estate altogether and thus avoid being subject to accumulation trust throwback rules.
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